Given the dominance of income in the return equation it is surprising that so few resources have been devoted to the analysis of tenant default risk, says Matthew Richardson

What is the most important element of the total return from commercial property? The intuitive answer is capital growth - that's why real estate is seen as a hedge against inflation. Actually, the biggest contributor through the inevitable ups and downs of the property cycle is income.

Here's how it breaks down. Between 1981 and 2008 the total return from the IPD UK All Property Annual Index was 9.7%* a year. Just 3.1% of that came from capital growth, while 6.6% was the income return. The capital gain was the net result of 24 years of rising property prices, eight years of losses and one year when prices moved sideways. The income, by contrast, was pretty steady, year in, year out.

Interestingly, capital growth actually failed to keep pace with inflation over the period. The RPI averaged 4.1%** so commercial property was a pretty poor hedge against rising prices unless the rental income was re-invested into the market.

Property closely resembles other asset classes in this regard. For bond investors the importance of reliable income is a given and a firm such as Fidelity spends a lot of time poring over the balance sheets of issuers to ascertain the likelihood of an individual company defaulting.

As a stock-picking house, the creditworthiness of each and every company whose debt we buy is as important as, or more so than, the overall direction of the market or our expectations about interest rates, time to maturity and the rest of it.

Less obvious is the importance of income to equity investors. However, according to the Barclays Capital Equity Gilt Study 2009, an investor who placed £100 (€116) in the UK stock market in 1945 would have ended up with £5,721 by the end of 2008 if he had spent his dividends as they were paid out but £92,460 had he reinvested the gross income.

In other words, something like 94% of the total return from UK shares is due to the compounding of the income return.

In the absence of capital growth, all assets are fixed-income style investments with a capital opportunity attached. In which case, one of the most important determinants of whether a real estate investment will be good or bad is not asset allocation or the direction of the market or lease risk but quite simply the ability of an occupier to keep paying the rent.

It is interesting, therefore, that the property investment business has been so uninterested in quantifying the risk of tenant default or in deciding how to price income. For us, putting tenants and not just properties under the microscope is fundamental to our investment process and it is our desire to be more scientific about how we go about this that has informed the development of the Fidelity Income Risk Monitor (FIRM) index of tenant default risk.

The index tracks the average probability of a UK tenant failing within a 12-month period. The index is compiled quarterly by aggregating 4.4m UK business failure scores from the Dun & Bradstreet (D&B) data file. The results are then grouped by standard industry code (SIC Code business types) to generate sub-indices by occupation or property sector.

D&B's Business Failure Score predicts the likelihood that a company will cease operations within the next 12 months. Rather than use insolvency as the definition for ceasing operations, the Business Failure scorecard instead looks at the onset of failure as signified by other legal events such as a meeting of creditors or the appointment of an administrator.

At the country level, the FIRM index makes the perhaps unsurprising point that business risk spiked sharply higher in the third quarter of 2007 as the credit crunch began to bite. The average probability of tenant default increased by around 100 basis points to just over 3%, where it has remained. Anecdotal evidence suggests that the default rate, although elevated, is lower than in the recession of the early 1990s when the failure rate peaked at around 4%.

Where the data become more interesting is at the sector level. Again some of the findings are unsurprising. They show, for example, that the hardest hit sectors have been in the hotels and catering industries where business and discretionary private spending have both fallen. Tight credit has had a significant impact on tenant default levels in the construction sector too.

By contrast retail, manufacturing and business services have experienced only a relatively modest increase in projected tenant default. Financial services, the sector at the heart of the crisis, has actually experienced a fall in the expected default rate.

The somewhat counter-intuitive reason for this is that the financial services sector is dominated by a handful of big companies that have been deemed too large to fail. Backed by the public purse, they are now safer than before the crunch.

This anomaly is confirmed when projected failures are segregated by property sector. Retail and industrial properties are most vulnerable to tenant default while the probability of defaults by office tenants has remained pretty stable as financial services and business services have effectively netted each other out of the calculation.

A similar analysis is possible at the sub-sector level. In retail, for example, pubs and restaurants are most at risk, followed by department stores, where a handful of highly geared private equity-owned businesses are vulnerable. Food stores, benefiting from the sub-sector's defensive qualities, bring up the rear, albeit at a significantly higher rate of potential default than two years ago.

Tenant default is only one input into the calculation of a risk-adjusted expected return for a commercial property investment but it has been given less thought than lease structure, sector allocation and market value movements until now. Coming from a bottom-up stock-picking background, we find this curious.

* Source: Fidelity - IPD Index
** Source: Fidelity - ONS

Matthew Richardson is head of research, Fidelity European Real Estate